Why Smart Contracts Won’t Replace Contract Law

New advancements in blockchain technology look to disrupt several industries and practices – contract law being one of them. Smart contracts, one of the many uses of blockchain technology, are self-executing and self-enforcing digital agreements that utilize decentralized cryptographic mechanisms. It is theorized that smart contracts will soon eliminate the need for contract law, thus sending this law profession into extinction. As feasible as this theory sounds, it falls short because it wrongly assumes that contract law exists for the sole purpose of enforcement. This article will discuss how smart contracts work and how they will help, not hurt, the contract law profession.

Evolution of Smart Contracts

Over the last decade, contracts have taken new form with the help of digitalization. Contracts can now be executed, and even enforced, online. There are four distinct levels of digital contracts: electronic contracts, data oriented contracts, computable contracts, and smart contracts.

Electronic contracts are contracts in digital form. An example of an electronic contract is the terms of service agreement you sign, but probably don’t read, before signing up for a website like Amazon or Facebook. Courts apply contract law to electronic contracts in the same manner as paper contracts so its substance and execution are still dependent upon human input.

Data oriented contracts are contracts in which agreed upon conditions are executable by a computer system. Purchase agreements are a form of this type of contract where a payment from one or more parties can be processed via electronic payment systems.

Computable contracts are contracts in which a computer system is given the power to asses performance or compliance, and take predetermined action based on its assessment. For example, when you pay for a monthly subscription the payment will ensure access to the product or service. However, if payment is not made then the subscription automatically expires.

Smart contracts, as previously defined, are both self-executing and self-enforced. The easiest example of a smart contract would be a vending machine. Money is put into a vending machine and the computer system determines the amount of the payment made. Next, the vending machine user chooses the desired product and the vending machine automatically dispenses the desired good. There is no intermediary needed and after the item is dispensed then the contract has been fully executed.

Blockchain and Smart Contracts

What makes smart contracts possible is blockchain technology. Described in more detail here, blockchain allows for secured payments with digital currency to be exchanged between parties through an immutable ledger. Blockchain technology could be incorporated into contracts allowing for them to be executed automatically, ensuring that no change or alteration to the original contract content has occurred. For example, two people wanted to make a friendly wager on the outcome of the next Superbowl. Both would agree to set aside $100 and based on the outcome of the game the funds would be transferred automatically from one account to the other.

Since contracts are self-enforcing, there is no need for intermediaries like courts or lawyers to ensure performance. However, smart contracts have their limitations and still rely on contract law for legitimacy.

Limitations of Smart Contracts

When determining whether or not a contract is valid the courts look at the substance of the original agreement. According to the standard legal definition, a contract is a promise or agreement that is legally enforceable – a smart contract that is not legally enforceable is not a contract at all. Even though the terms and conditions of the contract were automatically executed and enforced, remediation is still needed to determine whether or not the agreement was a contract to begin with.

Contracts that are illegal, unconscionable or fraudulent cannot be determined by the smart contracts themselves and therefore could not possibly replace the need for contract law. Smart contracts are therefore agreements that are self-executing and self-enforcing whether or not they are legally enforceable.

Even more so, a smart contract that is legally enforceable may not meet the desired requirements of a specific party involved. For example, the delivery of goods might trigger the automatic release of funds to the seller but the goods might not meet the specified requirements of the contract.

For example, the buyer might have wanted 100 blue mugs but instead received 100 red mugs. Performance can be subjective and therefore the need for contract law still exists.

Conclusion

Smart contracts, in their current form, do not constitute the end of contract law as we know it. However, smart contracts can be used to reduce transaction costs, ensure performance, and enforce the agreement. The main distinction between smart contracts and contract law is that smart contracts ensures enforcement while contract law aids in remediation.

For a more detailed analysis of this topic, read Kevin D. Werbach and Nicolas Cornell’s paper entitled Contracts Ex Machina.

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Jeremias Ramos is a CPA working at a nationally recognized full-service accounting, tax, and consulting firm with offices conveniently located throughout the Northeast. Jeremias specializes in tax and business consulting with focus areas in real estate, professional service providers, medical practitioners, and eCommerce businesses.